24.05.2023 Fiscal Policy#

Chapter 14

Aggregate Demand#

Aggregate Consumption

  • autonomous consumption = fixed amount based on future income

    • slope of function = marginal propensity to consume

    • additional consumption based on more income in period etc

  • 45° Line where AD = Aggregate Output

    • state of normal economy

  • Investment: does not depend on output

    • added to AD Line

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implicit assumption: underutilized capacity in economy

The multiplier#

A Decrease (or Increase) in Investments leads to a higher decrease in Income than the original

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  • original negative investment = 1.5bn€

  • expected point afterwards = C

  • but households now have less money and this leads to ripple effects = Z

Determining the Multiplier

\[\begin{split} Y = AD = C+I \\ = c_0 + c_1 Y+I \\ Y(1-c_1) = c_0+I \\ Y = \underbrace{\frac{1}{1-c_1}}_{multiplier} \times \underbrace{c_0+I}_{autonomous \ D.} \end{split}\]

with \(c_1\) = marginal propensity to consume

Household Spending#

Has Target Wealth: level to maintain based on expectations

optimizes broad wealth: assets - debt, including future earnings

Paradox of thrift (Sparparadoxon): aggregate attempts of all households to increase savings during a recession does not actually increase savings

  • Autonomous Consumption declines => AD curve downwards

  • Income + Labor Demand declines => Recession

  • higher savings at lower income = absolute lower savings

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Firms Investments#

Decicsions depend:

  • Discount rate p of owner (opprt. cost)

  • interest rate r

  • profit rate of investment \(\Pi\)

Investment when: \(\Pi > p+r\)

Example: individual firms

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The Aggregate Economy: sinking interest rates = more Projects

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Government and Imports#

Government Spending and Net Exports = shift 45° Line up

marginal propensity to import (m): fraction of additional dollar spend on imports of household

Net Exports \(= X-M = X-mY\)

Combined Formula

\[ AD = c_o + c_1(1-t)Y + I+G+X-mY \]

With t = Tax rate

Fiscal Policy#

How does Government Policy impact Aggregate Demand and the Business Cycle?

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=> severity of Business cycle shrinked with bigger government

Policy before Keynes#

after David Ricardo:

  • wages and prices adjust

  • no long-term disturbances

  • only role of government = avoid deficits

=> orthodox policy = austerity

Economics: Allocation of scarce resources

Policy after Keynes#

in the long run, we’re all dead

  • government intervention can provide benefits to society

  • due to the money multiplier

  • the effect of fiscal stimulus is more than the money used for it

Economics: study of how agents allocate resources and how those choices affect society

Government Role#

Stabilizing

  • non-cyclical expenditures (education)

  • income redistribution (consumption smoothing)

  • investments in recessions

Destabilizing

  • trough Austerity in Crisis

  • political business cycle

Depends on Multiplier:

empiric research suggests: multiplier in crisis is above 1 (even IMF says so) and austerity is therefore a very dumb idea…

The Multiplier over the business cycle:

  • in crisis: high because of anticipation and underused capacity

  • in booms: lower (but often above 1)

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Governments finances#

Revenues

Expenditures

Income Tax

social transfers

Value Added Tax

public investment

Inheritance Tax

interest

Definitions:

primary budget deficit: revenou minus expenditures (excl. interest)

sovereign debt crisis: situation, where gov. bonds are deemed to risky, -> not abel to borrow

Instruments for sustainable debt:

  • running surplus (in booms)

  • creating inflation

  • benefitting g > r

AD and unemployment#

Supply Side

Demand Side

labor market model

multiplier model

Medium-run: wages + prices change, all other const.

short run: employment changes, al other fixed

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Connected by: production function

\[ Y = \lambda \cdot N \]

  • N = employment

  • \(\lambda\) = labour productivity

both connected:

  • shifts in AD: cyclical changes in employment (but not curve shifting anywhere)

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